Hard Money Loan: Definition And What To Watch Out For

If the phrase "hard money loan" makes you think of quick and easy business deals that end in "cold, hard cash," you’re not too far off the mark. However, just because this type of loan offers fast financing doesn’t mean it’s a good, safe option for everyone.

So, what are hard money loans and should you be wary of them? Let’s examine what you should look out for and also consider the pros and cons of hard money loans.

A hard money loan is a short-term, non-conforming loan for commercial or investment properties, that doesn’t come from traditional lenders, but rather people or private companies that accept property or an asset as collateral. Commercial borrowers may turn to hard money loans after having a loan or mortgage application denied, or to avoid the lengthy process of getting approved for a loan through traditional means.

Like a traditional mortgage, a hard money loan is a secured loan, guaranteed by the property it’s being used to purchase. The "hard" part of "hard money" refers to the tangible asset being used to back the value of the loan. When someone defaults on a secured loan, the lender can take ownership of the asset to recoup its losses.

Unlike traditional mortgages or other types of secured loans, hard money loans come with a fast and typically less stringent approval process, making them ideal if a purchase needs to happen fairly quickly.

With a mortgage, it often takes more than a month, from application to close, to purchase a property. With hard money loans, it’s possible to close in just a few days.

Let’s take a look at how hard money loans work compared to more traditional forms of financing.

Traditional Loan

Though not a formally defined category, "traditional" in this context refers to loans taken out through a familiar process: You apply for a loan, the lender checks your credit and ensures you have the ability to repay them, and – if the lender determines that your finances meet their standards – you’re approved for the loan.

Many types of loans fall under this umbrella, including mortgage loans, auto loans, personal loans and home equity loans. Though it’s usually possible to get these types of loans from private lenders that don’t have the same requirements as traditional lenders, these private loans can be more expensive and less advantageous for borrowers, because the risk is much higher.

Traditional lenders will take a thorough look at your entire financial situation, including your income, the amount of debt you owe other lenders, your credit history, your other assets (including cash reserves) and the size of your down payment.

These lenders go through this sometimes lengthy process to minimize the amount of risk they take on when they lend money. By ensuring their borrowers are creditworthy, lenders can offer better rates and more affordable financing.

Many types of traditional loans are available to explore, even if you think you might not meet the requirements.

How to Get A Hard Money Loan

With hard money loans, the lender approves a borrower based on the value of the property being purchased.

The lender may do a quick check of your credit or finances, but in general, the process will be much less rigorous than with a traditional loan. This allows the process to happen more quickly so borrowers can get their money in a matter of days instead of weeks or even months.

The downside of this process is that the lender takes on significantly more risk, which translates to a more expensive loan for the borrower. Hard money loans typically come with high interest rates, and lenders might require larger-than-average down payments (though this isn’t always the case).

Hard money loans also tend to have short repayment periods – often just a few years. Compare this to traditional mortgages, which commonly come with 15- or 30-year terms.

Here are some common reasons that people seek out hard money loans instead of traditional loans.

Flipping A House

Real estate investors who make money by purchasing low-cost properties in need of fixing up, making value-boosting repairs and renovations and then flipping the homes for profit may utilize hard money loans.

Because these projects typically happen fairly quickly, professional flippers often prefer faster forms of financing. Additionally, because house flippers generally try to sell the home within a short period of time – typically less than a year – they don’t need a lengthy loan term you’d get with a traditional mortgage.

Purchasing Investment Property

Those who want to invest in rental property but don’t qualify for traditional financing might seek out a hard money loan to pay for their investment.

This method can be useful if you can’t get approved for a traditional loan due to credit history or you need more money than a traditional lender will let you borrow.

Purchasing Commercial Property

Similarly, a business owner might use a hard money loan to fund the purchase of commercial real estate if they’re unable to secure traditional financing. Hard money loans can be useful for entrepreneurs purchasing a unique property that doesn’t qualify for conventional financing. The same may be true for those who find traditional commercial loan limits insufficient for their needs.

Hard money lenders are generally private investors or companies that deal specifically in this type of lending. You won’t find hard money loan options at your local bank. Hard money lenders aren’t subject to the same regulations as traditional, conforming loan lenders. As a result, hard money lenders are, for the most part, free to make their own rules about credit scores or debt-to-income ratios they require from their borrowers.

It’s possible to find a hard money lender who will give you a loan even if you’ve been denied by more traditional lenders. For hard money lenders, the most important factor isn’t the borrower’s creditworthiness, but the value of the property being purchased.

As noted, hard money loans are expensive. Just how expensive? Let’s compare interest rates on these loans to more traditional loan types.

In May 2022, the average rate on a conventional 30-year fixed-rate mortgage was 5.09%, according to Freddie Mac. Hard money loans can have much higher interest rates, often 8 – 15%.

Hard money loans can also be more expensive depending on the preferred loan-to-value (LTV) ratio of the lender. If a lender will only finance 70 – 80% (or less) of the property’s value, you’ll likely need to bring a sizable down payment to the closing table. If you don’t have the cash for this, you might have a tough time finding a hard money lender who will work with you.

If you’re thinking about getting a hard money loan, make sure you understand all the advantages and disadvantages that come with this type of loan.

Hard Money Loan Pros

As mentioned, the pros of using a hard money loan include:

• Faster approval process
• Approval based on property, not credit history
• More flexible
• Less strict underwriting
• The opportunity to fix and flip properties

Hard Money Loan Cons

The drawbacks of hard money loans include:

• High interest rates
• Often require large down payments
• Shorter terms mean less time to repay
• Riskier than traditional financing
• May require a track record of successful house flips

If you’re not interested in a hard money loan, consider these alternatives:

• Private money loan: You can reach out to family, friends or others for a private money loan. Although it may feel a bit uncomfortable, it could be an option.
• Home equity line of credit (HELOC): A HELOC is useful when you want to embark on a home improvement project to increase the value of your home.
• Homestyle® loan: Another option is a Homestyle® loan from Fannie Mae. It’s a government-backed mortgage that allows you to renovate your home.

Hard money loans can be a useful tool if you need financing through a less traditional route. However, these loans come with high rates and a significant amount of risk if your investment isn’t as successful as you hope. In general, hard money loans are best left to the pros.

If you’re looking for alternative financing because your mortgage application has been denied, it’s better to explore other options such as working on rebuilding your credit or applying for a mortgage program like the FHA loan program that accepts people with a less-than-stellar credit history.